University at Buffalo study finds short sellers not responsible for 2008 economic crisis

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Short-sale stock trades did not trigger the 2008 worldwide economic crisis, according to new research from the University at Buffalo School of Management.

Short sellers were widely blamed in media coverage for causing stock prices to plummet and hastening the collapse of a handful of huge financial services companies. Restrictions put in place since the economic crisis essentially ban a type of trade known as the naked short sale, in which sellers do not borrow a security prior to initiating a trade.

But the UB analysis of naked short sales and “fails-to-deliver” in the days before and after the stock crashes of several firms found that these sales were not responsible for falling stock prices. Fails-to-deliver are trades in which the shares are not delivered within a three-day trading cycle.

“Short sellers have been accused of using fails-to-deliver as a way to cause sharp declines in stock prices and profit from the resulting collapse of several major financial institutions,” said UB researcher Veljko Fotak, assistant professor of finance and managerial economics in the School of Management and co-author of the study. “However, we found that on most days there weren’t enough settlement fails to cause significant price changes. And when fails were unusually high, it was only after price declines generated by other negative economic news.”

The study will be published in the Journal of Financial Economics. The U.S. Securities and Exchange Commission began prohibiting naked short selling in 2008.

Fotak and collaborators from Warwick Business School and the University of Oklahoma examined 1,492 New York Stock Exchange and 2,381 Nasdaq common-share trades from January 2005 to June 2008. The research found that the impacts of short sales that fail to deliver and those that deliver on time are similar, and both largely are beneficial for the market.

“Our results clearly show that restricting fails-to-deliver hurts the market,” Fotak said. “These trades affect market liquidity and significantly reduce pricing errors, order imbalances and volatility over a single day.”

Instead of banning naked short sales, Fotak said regulators should focus on eliminating economic incentives for delivery failures by improving liquidity and transparency.